Tuesday, December 9, 2008

For several years, I have been among those calling for thoughtful, prudent, moderate steps for the reform of the credit default swaps market...

I was wrong. The global credit default swaps market should just be liquidated, the contracts allowed to expire and the booby traps defused....

Essentially, while the back office messes of the CDS market are being cleaned up, that leaves the question of why we need these things. We don't. The outstanding credit default swaps should be offset against each other, where possible, and the rest allowed to run off or be paid out as defaults occur.

Some of the counterparties will default; those losses should be accepted as the price of another huge pile of wasted effort, along with cold war bomb shelters and media studies doctorates.

As credit default swaps have come in and out of focus over the last year, I have been struck by the assumption that this product would of course continue to exist. I have trouble seeing their legitimate uses. In theory, they could allow banks to diversify and hedge credit risks better, but once risks rise beyond a modest level, CDS pricing looks to equity markets rather than debt for reference points, which begs the question of the validity of the risk methodology. And there were periods last year when high rated credits (and I mean decent ones, not ones suspected of being rating agency fictions) had their fundraising costs pushed to bizarrely high levels due to the arbitrage between cash bonds and CDS. In addition, the use of CDS had lead to a hollowing of credit risk assessment skills and a ballooning of speculation.

We hear....that three primary banking institutions in Europe, two French and one German, have such significant CDS exposure and other problems that they cannot even begin to fund the payouts anticipated over the next quarter.

The funding squeeze reportedly is exacerbated by a near-collapse among weaker players in the hedge fund market, who were accustomed to receiving loans from one large French institution, which then stupidly converted the loans into equity. That's right. This past summer, when the bank put out a call for redemptions of $4 billion in hedge fund investments, says the source, only $400 million was returned. And the French bank also used these same hedge funds and others to reinsure some of its own CDS exposure. Sound familiar? Yup, just like AIG.

Unlike the approach taken by Paulson and Geithner to bailout AIG and JPM (via the Bear Stearns rescue), however, the investor claims that EU officials are considering a moratorium on CDS payments by the three Euroland banks in question. The banks would be given ten years to write down their CDS and hedge fund exposures and would receive additional infusions of capital by their respective governments. The source claims that French banks have such huge exposure to both hedge funds and CDS, sometimes linked together, that the positions are beyond the ability of the EU governments to bail them out without a cessation of CDS payments......if this unconfirmed report turns out the be true, then the beginning of the end of the CDS market as we have known it will be at hand....

In the event, as other governments around the world follow the very reasonable example of the EU, the OTC derivatives market will implode and these unfunded liabilities may very well force the nationalization/liquidation of C, JPM and AIG, among others. And in the event, Hank Paulson, Tim Geithner, Alan Greenspan, Ben Bernanke and other senior officials at the Fed in Washington are going to have a lot of explaining to do to the Congress, to a new President and the global financial community.

Tell us again, Chairman Greenspan and Chairman Bernanke, just why do you believe dealing in OTC derivatives and particularly CDS contracts are activities that are safe and sound for global banking institutions?

Note: If American politicians don't have the guts to cancel CDS, they should at least do what the Europeans are considering: freezing all CDS payment obligations for 10 years, so that we can dig our way out of the current crisis and buy some time.

4 comments:

I'm still not buying the whole 'toxic mortgage backed securities as the cause of the world financial collapse', and the subprime market unable to pay their mortagage is at fault story.

Here's some data from http://www.federalreserve.gov/releases/chargeoff/chgallsa.htm

I’m an amateur in this realm,(not a professional economist),but more than a few years of formal education and experience. Am I to believe that a charge-off rate of 0.15% of mortgages, and 0.51% of total loans in 1Q/2007 started this whole problem of ‘toxic mortgage backed securities’ that caused this collapse, as is being attributed by the media? Even today the rate is 1.58 and 1.89 for residential and total charge-off rates. It doesn’t feel right to me. I take risks 20 times that big every day and I’ve made money for a long time.

Am I reading the data wrong? Other explanations?

I've posted this to a couple of other blogs; no response - whats what? If I'm reading it wrong, or just being stupid, somebody explain...

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